Valuation of the closely held business

Reaching a range of values for a small business involves a unique set of questions and factors

To value a business is to develop an informed estimate of the value of the business as a whole. A value may also be developed for a segment or share of the business.

As in other types of valuation, the valuation of a closely held business is not an exact science. It is, at least to a certain extent, an art based on the professional experience and informed judgment of the valuation professional.

The valuation process involves many factors, ranging from standards set by certification authorities, to IRS pronouncements, to common sense. Outside factors, including market forces, affect each valuation to such an extent that any of three valuation approaches -- asset approach, income approach and market approach -- may apply. Each approach includes a number of valuation methods that have been developed over the years.

Basic questions

There are several basic questions that need to be answered before a business can be valued.

• What is the date at which the business is to be valued? The value of a business today may well be different from the value of the same business three months from today.
• What standard of value is to be applied in valuing the business? There are several established standards of value, including fair market value, intrinsic value, investment value, fair value and book value. While all these standards of value are legitimate, their use is situation driven.
• Most important, what is being valued? Is it the stock of the business? Is it the business less both cash and accounts receivables? Is it a portion of the shares of the business?

The value of a business will differ among different classes of buyers because each class of buyer has a different perspective of value. A profitable business may have a value to its owner based on the cash flow generated. But the value to a purchaser depends largely on the reasons behind the purchase.

Determining factors

There are many factors to take into consideration when valuing a business. Some of these are:

• the reason the business is being valued
• the nature of the business
• the history of the business
• the general economic outlook
• the economic outlook of the region and the industry in which the business operates
• the business’s current and future financial condition

A valuation professional will probably factor in the answers to questions such as these:

• Is there a key person without whom the business could not continue as profitably? Does the business have an indispensable supplier? Does the business have an indispensable customer?
• Does the business own any patents or copyrights? When do they expire?
• What are the nature, level, and skill set of the business’s work force?
• Do the physical plant and technology infrastructure meet both current and future needs?

Financial information

In valuing a business, one must be careful to ensure that the data that is used, while historical in nature, is indicative of the future.

Most valuations will be based on historical financial data. There are times, such as valuing a start-up, where historical information is nonexistent and the business valuator will use financial forecasts.

It’s common for a valuator to make adjustments to normalize the financial information presented. For example, an owner may pay himself substantially more than what similar businesses would pay for the same duties he performs. A valuator might also make an adjustment to normalize the income of a closely held business to eliminate any personal expenses of the company’s owner that were paid directly by the company.

Conclusion

A properly prepared valuation of your business will give you a reliable range of values in the context of your purpose in determining that value. Additionally, many business owners have found that, through the valuation process, they know far more about their company and its future than they did before the process began.

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